What are "Securities"?
Stocks and Bonds
In this context, "securities" include stock (equity) and bond (debt) rights -- the two basic forms of ownership and control of the capital in a business entity.
Investment contracts
"Securities" also include various types of contracts and entities where someone invests money/ property in a common enterprise expecting to make a profit from the significant efforts of others. (SEC v. Howey, 328 US 293 (1946).)
Legal Regulation of the US Public Capital markets
Extensive regulation of the sale of new securities to the public, and of the public trading of existing securities by the U. S. Securities and Exchange Commission, an "independent administrative agency" of the Federal Government, with 5 commissioners appointed by the President.
Theme of the law is not "paternalistic" protection of investors from bad investments, but "transparency" -- full public disclosure of known facts. People are allowed to make dumb investments, but they do so with access to all material facts. No more of the "project to be carried on to great advantage, but no one to know what it is."
Basic law was a response to the stock market crash of 1929-1932. The Dow Jones Industrial Average fell from a high of 374 in September, 1929 to a low of 47 in January, 1932, setting off a worldwide economic depression.
The "1933 Securities Act" regulates the sale of new securities to the public.
Applies to Initial Public Offerings as well as new securities sold by established companies
Generally, the company issuing the securities must register them with the SEC unless they are exempt. There are both criminal penalties and civil liability to the purchasers if non-exempt securities are sold without registration.
Technically, must register if nonexempt securities will be sold using postal system or interstate commerce. Reason: 1933 Act based on constitutional power of Congress to set up post office and regulate interstate commerce.
Preparing the Registration Statement and Prospectus
Who is involved: Co, attys, accountants, investmnt bankers/"underwriters". ("U'writers" = brokers who will distribute the securities to the public buyers
Typically a firm underwriting (u'writers bear risk of shortfall in public demand) or "best efforts" (for shakier/ more speculative situations
What's in a Registration Statement filed w/ the SEC.
Usually use Form S-1. Example: Cotelligent CGZ
Need audited financial statements in the format specified in Regulation SX. This gives SEC a lot of power over accounting profession (see, for example, Reg. S-X Rule 2-01) and a lot of power over what is GAAP (See Rules 5-02 and 5-03)
Registration statements, etc. are public documents. Now accessable on-line thru Edgar or an Edgar "front-end"
The SEC doesn't consider the "merits".
Stupid investments are allowed. But the staff does consider the sufficiency of disclosure and may require amendments
Limitations on sales activities during registration
- Cannot sell or offer to sell during prefiling period
- During waiting period (registration filed, not yet "effective"), cannot sell, but can offer to sell and distribute a preliminary prospectus. "Tombstone" ads by underwriters.
- Once its effective: deliver final prospectus and close the sale
New Issue liabilities
- Criminal liability for wilful violation (rare)
- Injunctive relief sought in court by SEC:
- often resolved w/ consent order: negotiated settlement
- "I didn't do it and I won't do it again"
- Buyer lawsuits for rescission under Sec. 12 for misrepresentation in offers to sell
Private lawsuits for damages
If reg statement is false as to a material fact or omits facts necessary to make it not false ("securities fraud")
Not need to show specific reliance by purchaser, and frequently brought as class action: on behalf of all purchasers
Who is liable: those who acted intentionally or negligently
- Company
- Officers who sign reg st: Pres, Chief financial / acctg officer
- Directors (at least 1/2 must sign)
- Underwriters
- Experts (atty and acct) as to portion they expertise
"Due Diligence" as a defense
"We acted reasonably and no reason to know of falsity/omission
Non-experts may rely on experts unless they know info to contrary
Experts: due diligence as to portions they prepared
Auditors as experts
Financial statements (last 3 years) must be included in reg. st and prospectus
Auditors prepare only the opinion letter: an "attestation" as to the material fairness of the financial statements: that they "fairly present in accordance with GAAP"
In order to make sure last annual report still fairly presents, need to do an update or interim or "S-1" review
Escott v. Bar-Chris famous case: an S-1 review failure causing auditor's liability (Peat Marwick)
1933 Act Registration exemptions
Exemptions due to nature of security or issuer
- Governmental organizations
- commercial paper due in less than 9 mos
- not for profit securities
- savings and loan securities
- insurance company policies and contracts (note state regulation)
- reorganization securities
Exemptions for small offerings and for single state
Tho States have their own securities laws covering single-state offerings. See Cal Corps. Code Sec. 25100 and following.
Exemption due to nature of investors
Concept of "accredited investor": millionaires, or regular Y over $200 k/year, or corp w/ => $5 mm in assets, or insiders of the issuer, or institutional investors
"Rule 144" stock: "lockup periods" and restrictions on volume sold for shares issued in private placements or small offerings.
Must be "legend" on the stock
Rule 144A: institutions over $100 m can buy and sell to each other w/o 144 time restrictions
"1934 Securities Exchange Act" and Public Trading
Issuer Reporting requirements
If securities registered under '33 Act or traded on a national exchange, required public (now on-line) filing of reports: Annual 10-K, quarterly 10-Q, extraordinary event 8-K
See Form 8-K in Rule 13a-11 for the triggering events, and Form 10K for prescribed disclosures // x-ref reg. S-X
Annual reports must be audited.
See Sec. 10A (@ 1996 Amendments) for the duty of auditors to detect and report fraud.
Control over the format for presentation gives SEC lots of potential power over the accounting profession. See Sec. 13(b)(1) of '34 Act
Tho a lot still left to the self-regulatory process of the FASB
Reporting requirements for stock trades
13G, 13D (and 13F for investment managers). insiders and >5% owners have to report transactions
Proxy Contest Regulation: Rule 14.
An area of "takeover contests" Eg LNV management vs. challenger
Regulation of exchanges, brokers and dealers
see Sec. 6 of '34 Act, and Sec. 11 which regulates trading by members of exchanges: "market" insiders
Rule 10(b)-5
Vaguely worded anti-fraud/deception regulation became the basis for '34 Act private securities lawsuits/class actions.
Intense lobbying by Big 5 firms concerned about "joint and several liability" To raise the standard of liability. Do Big-5 Auditors ever get entangled in securities fraud?
"Insider trading"
Insiders can (and do) trade stock in the companies they run. (Typically insider sales exceed insider purchases by about 2:1
The SEC investigates "suspicious" trades which may involve the improper use of material nonpublic information. If you want to trade, be prepared to disclose.
There are $$ REWARDS $$ for giving the SEC information to catch the illegal type of insider trading.
States regulate who can practice a profession
(Sometimes there may be self-interest in limiting competition)
California has a State Board of Accountancy
Who is an "accountant" in California? Moore v. State Board of Accountancy
New Developments in California CPA licensing
See 8/2/01 State Board Update. Two different "pathway" combinations of education and experience, and a seperate "attest" requirement
The end. Whew! You made it this far. 10 classes, four hours each is "learning the hard way." Good luck with your regular classes in the Fall.
